DUBAI, June 16 (Reuters) – For years, the rich oil states of the Gulf have struggled to insulate themselves from political turbulence in the rest of their volatile region. Marketsâ€™ reaction to the insurgency in Iraq suggest they may finally have succeeded.

Saudi Arabia and Kuwait face the potential disintegration of a country on their borders. At the very least, the turmoil in Iraq looks set to widen the Sunni-Shiâ€™ite divide which has poisoned politics across the region.

But in contrast to past episodes of instability in the Middle East, the Gulfâ€™s financial markets are mostly reacting calmly. Foreign investors have continued to plow hundreds of millions of dollars into Gulf bonds. There have been no signs of pressure on Gulf currenciesâ€™ pegs to the U.S. dollar.

Stock markets have dropped, but traders largely see that as a natural adjustment after big gains earlier this year, not a panicked response to geopolitical risk. The calm reflects the Gulfâ€™s progress in building up its financial resources on the back of high oil prices as a defense against regional instability, as well as its success in containing domestic political fallout from the Arab Spring uprisings over the past three years, economists and fund managers said.

â€œI think people now see the Gulf as well insulated from the politics around it,â€ said Jason Tuvey, Middle East economist at Capital Economics, a London-based consultancy. He added that apart from Saudi Arabiaâ€™s Eastern Province, which has seen some low-level unrest among its Shiâ€™ite minority, it was difficult to see how events in Iraq could have any direct impact on Gulf states. If there is any impact, governments have the monetary and security resources to deal with it, he added.

GEOPOLITICS

The region has been buffeted by a string of geopolitical shocks since early 2011, when revolutions in Egypt and other Arab states briefly raised the possibility of similar unrest within the Gulf.

Five-year Saudi Arabian credit default swaps – which insure against the risk of a Saudi sovereign debt default, and are therefore an indicator of foreign investorsâ€™ jitters about the Gulf – shot up to a peak of 140 basis points in February 2011.

They rocketed back to that level in early 2012, as international tensions over Iranâ€™s nuclear program rose. A smaller spike occurred in August 2013, as the United States threatened to bomb Damascus over the use of chemical weapons.

This month, however, CDS have stayed low, sliding to 37 bps last week, the lowest level since early 2013. The Saudi riyal forwards market, which shot up during the Arab Spring to show expectations for riyal depreciation, has barely moved.

In another vote of confidence in the Gulf, United Arab Emirates telecommunications operator Etisalat sold $4.3 billion worth of bonds last Wednesday in the regionâ€™s biggest corporate bond issue ever.

The sale, a day after the Iraqi insurgents seized the major city of Mosul, attracted massive demand from European fund managers in particular and set a record for the cheapest pricing of any Gulf bond relative to mid-swaps, bankers said.

Shakeel Sarwar, head of asset management at Bahrainâ€™s Securities & Investment Co, a major fund manager, said the markets recognized that the six Gulf Cooperation Council economies could function smoothly next to an unstable Iraq.

â€œUnless the contagion spreads to the entire region and it becomes a serious conflict, the probability of which is quite low at present, I donâ€™t think that a contained conflict limited to Iraq is going to negatively impact the GCC economies,â€ he said.

SPENDING

One reason for the growing confidence in the Gulf is that three years of high global oil prices have allowed most governments to build up their financial reserves, leaving them in better shape to cope with any political or economic shocks.

Saudi Arabiaâ€™s net foreign reserves, for example, have ballooned by over a third since 2011 to $730 billion – enough to finance several years of state spending at current levels even if oil revenues plunged tomorrow.

Also, in contrast to Iraq, GCC governments have over the past three years shown they can spend their oil money effectively to maintain social peace. Riyadh has directed tens of billions of dollars towards social benefits, new housing and new jobs to avert any pro-democracy unrest.

Compared to three years ago, â€œgovernments are better prepared to confront the sectarian threat, the fiscal reserves they have to do this with are bigger, and macroeconomic conditions are better,â€ said Raza Agha, chief economist for the Middle East and Africa at VTB Capital in London.

He noted that since the Arab Spring, the GCC states had also developed a mutual support mechanism, with the richest governments – Saudi Arabia, the UAE, Kuwait and Qatar – pledging $10 billion each to the less wealthy ones to fund economic and social welfare projects.

If Iraqâ€™s sectarian confrontation sucks in Iran on the Shiâ€™ite side, the Sunni monarchies of the Gulf could conceivably drift towards a conflict that damages their economies and endangers their security. This would have a major effect on financial markets.

Even then, however, the financial position of the Gulf states could become stronger in some ways, as higher oil prices boosted their revenues.

Iraq has been producing around 3.5 million barrels of oil per day; if that were lost because of fighting, much of it would probably be replaced by Saudi Arabiaâ€™s almost 3 million bpd of spare capacity, raising its revenues substantially, Tuvey said. (Additional reporting by Olzhas Auyezov; Editing by Giles Elgood)